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GIM Solutions-GMAG –
Weekly Strategy Report
11th November 2014
Deflation fears in the eurozone
ECB forecasts consistently
overestimated actual inflation
Lower long-run inflation expectations,
which were assumed to be anchored,
may partially explain this
If expectations have indeed reset
lower it intensifies the need for
decisive ECB action
Chart of the week: eurozone HICP if
expectations had not dipped
This document is produced by the Global
Strategy Team within GIM Solutions-GMAG.
For further information please contact:
Editor: Patrik Schöwitz
[email protected]
Michael Albrecht
John Bilton
Michael Hood
Beth Li
Jonathan Lowe
David Shairp
Chart of the Week
Our chart of the week shows how a
rudimentary model of European inflation
arrives at a level of current HICP ca. 1ppt
higher than the actual inflation rate, if
consumers’ inflation expectations are
“held” static at their pre-eurozone crisis
level while other variables are allowed to
follow their natural evolution.
In November 2011 eurozone core inflation stood at 2%, while in Japan it had
dipped to -1.1%. Roll forward three years, and the impact of a decisive central
bank response on deflation is clear: Japanese CPI is grinding higher, to 0.6%–
according to Bank of Japan (BoJ) estimates which exclude the consumption tax
hike, while Eurozone headline inflation has fallen to just 0.4%.
True, the long-run effectiveness of the BoJ’s policy remains to be seen, but the
European Central Bank’s (ECB’s) shortcomings in fighting the threat of deflation
are hard to overlook. The ECB’s dovish rhetoric last week may indeed be laying
the foundations for future quantitative easing (QE), and we acknowledge that the
ECB is starting to take more concrete steps, such as the TLTROs and the asset
backed securities purchase programme. But to truly reverse the threat of deflation,
more decisive action is likely now needed.
The ECB projects low but positive inflation, with the harmonised index of consumer
prices (HICP) forecast to be 1.2% in 2015 and 1.5% in 2016 – numbers which now
look set to be revised lower. Despite the ECB’s dovish inflation forecasts, since the
end of the eurozone crisis they have consistently overestimated the inflation
outlook. So it is reasonable to ask whether the ECB are continuing to do so, and
whether the risk of deflation is more asymmetric than is acknowledged.
Our conceptual view of inflation considers three factors. First, is “supply side”
inflation – proxied by food, energy and other commodities that react quickly due to
the continual price discovery process in their own markets. Next is consumer
“demand side” inflation – which proxies to real wages and tends to reflect the
output gap. Finally, there are “inflation expectations”, which history suggests are
slower moving and tend to run across several business cycles.
U.S. consumers’ inflation expectations are remarkably stable; since 2000 the
University of Michigan Survey of 5-10 year ahead inflation expectations fluctuated
by just 0.9ppt – between 2.5% and 3.4% p.a. – despite the deepest recession
since the 1930s. While there is no equivalent series in Europe, 12 month forward
consumer price expectations – part of the eurozone consumer sentiment survey –
suggest a steady decline in aggregate inflation expectations since the crisis.
There are several possible reasons for the ECB’s overforecasting of HICP, such as
incorrect estimates of the aggregate output gap and the difficulty in aggregating
divergent core and periphery data. However, another plausible explanation is that
aggregate inflation expectations were less well anchored than they had anticipated.
In part, this may arise due to the lack of data in Europe on inflation expectations;
equally it may be driven by overemphasis of the likely higher inflation expectations
in core nations, relative to persistently lower expectations in the periphery.
Eurozone Inflation: what might have been if expectations were stable
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4
HICP Modelled (Consumer price expectations held at pre-Euro crisis level)
HICP Modelled (Long-Run average of Consumer price expectations)
HICP Modelled
HICP Actual
3
2
1
0
Sources: Bloomberg, J.P. Morgan Asset Management.
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2004
2005
2006
Note: Simple regression model of HICP from unit labour cost, blend of leading
and trailing 12m consumer inflation expectations, and HICP food and energy
sub components. Estimates made by holding inflation expectations static for an
in sample period at i) long term average, and ii) pre-eurozone crisis level
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2007
2008
2009
2010
2011
2012
2013
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GIM Solutions-GMAG
Weekly Strategy Report
Miscellaneous Musings
At times of uncertain growth, a
glance at IMF nominal GDP
projections can be interesting. In
2015, world nominal GDP was
forecast to rise by USD 4.34 trillion
to USD 82.1 trillion – the equivalent
of adding another Italy, Spain and
Netherlands to the world economy.
Staying on this theme, the
bogeyman of a Chinese hard landing
is never far from the surface, but if
the IMF is right and China does grow
nominal GDP at 10.7% next year, it
will add another USD 963 billion to
global output. This is the equivalent
of adding another Indonesia to the
world economy, and as much as the
168 smallest contributing countries
to 2015 world nominal GDP growth
combined.
So what of the eurozone? The IMF
expects a creditable USD 270 billion
of nominal GDP to be added in 2015.
On the face of it, not bad for a region
mired by recession. But this is the
equivalent of adding another Egypt
to the world economy in 2015; and is
just a fraction of the USD 1.6 trillion
that BRIC nations (Brazil, Russia,
India and China) are expected to add
to world output next year
The difference in stability of inflation expectations between U.S. and European
consumers may well be due to the different approach of the Federal Reserve (the
Fed) and the ECB. While few would disagree that the ECB has achieved a great
deal with language alone, the Fed responded more decisively to falling inflation –
when U.S. 5y5y inflation dipped below 2% in August 2010, the Fed enacted QE-2.
The result was that US consumers barely had time to register the short dip in core
CPI to 0.6% in late 2010, before stimulus kicked in and drove the rate back up.
By contrast, European consumers suffered a combination of austerity, central bank
inertia and a dysfunctional banking system for far longer, and periphery nations are
now living with deflation. It seems that this backdrop weighed heavily on aggregate
inflation expectations. But even then, persistently low inflation expectations do not
automatically translate to deflation – the toxic combination of negative inflation
levels and expectations of lower prices in the future are needed for deflation to take
hold. In the last 70 years we have only one example of persistent deflation, which
is Japan; elsewhere, falling prices for goods and services are not a common
phenomenon. However, inflation expectations that are anchored near zero create
an asymmetry of risks – a shock such as a sharp fall in energy prices, or downward
pressure on wages, can quickly lead to a deflationary episode.
Eurozone inflation expectations are probably now anchored at a low but positive
level and, absenting ECB action, are likely to stay there. This does not inevitably
mean a slide into deflation but there are unwelcome side effects. First, it leaves the
eurozone vulnerable to deflation shocks – potentially a headwind for equities.
Secondly, savers are likely to maintain a clear preference for bank deposits and
bonds – if investors’ longer run inflation expectations are anchored at a low level,
they’re more likely to view any inflationary shock as temporary and adjust their
savings rate, but not the asset composition, to accommodate it. Third, low inflation
expectations across the eurozone slow the pace of much needed rebalancing
between the core and periphery. Finally, deflation risks threaten the recovery in
indebted periphery nations and are a disincentive to capital investment.
The net effect is interesting – the lack of growth stimulus and clogged credit
channels in Europe leave corporations and individuals less able to benefit from the
structurally low interest rates that are a consequence of low inflation. However, the
internationalisation of bond markets means that Europe is effectively exporting
these low rates to other regions, which can benefit from them. We believe that the
U.S. in particular is seeing the manifestation of Europe’s battle with deflation in the
compression of long-end Treasury yields. In turn, U.S. corporations are delivering
outsized equity returns in part because of the low costs of funding.
For Europe to start to benefit from the low inflation and low yield outlook, rather
than simply exporting it, the ECB will need to move from words to actions. As the
experience in Japan, the UK and the U.S. suggests, it is ultimately the delivery of
stimulus, not the promises, that resets longer-run inflation expectations higher. On
balance, we think it unlikely that the eurozone, on aggregate, will slip into deflation;
but until that threat is lifted Europe’s low yields may remain more of a benefit for
other regions, than for Europeans themselves.
John Bilton
All data sourced from JPMAM, Bloomberg, and Datastream, unless stated otherwise.
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